Incentive Based Policy
Tax Incentive Policy - a potential response to negative externalities
Governments recognize that increasing the price of something will decrease the demand. So, one way governments can attempt to mitigate the bad effects of a negative externality is by levying a tax on the harmful production. For example, the government may impose a tax of $5.00 per unit on steel produced. This tax increases the total production cost by $5 per unit. The goal is to decrease the demand for steel. This decreased demand for steel should result in less pollution as less steel is produced. This type of policy may also be called a corrective tax. The efficient tax is one that makes up the difference between the private marginal cost and the social marginal cost.
While a corrective tax is typically more efficient than direct regulation policies, corrective taxes are typically fairly inefficient. There are a number of reasons for this, but some of them include the difficulty in accurately measuring the social marginal cost and/or the social marginal benefit (often limited by political corruption and red tape). Other important reasons tax incentive policies my not be most effective are tied to concepts of Elasticity and Tax Incidence.
Subsidy - a potential response to positive externalities
Some of the positive externalities associated with an educated population include lower crime, higher property value (higher property tax), better health, and better informed voters. All of these "extra" benefits of an education give governments an incentive to subsidize student learning. In the United States many states subsidize secondary education for its citizens in the form of "in state tuition". With a lower price for a university level education, we can expect an increased demand for education. With a population with more people educated at a university level, states often enjoy the positive spillovers that educated people bring to society.
Market Incentive Policy - tradable permits
Historically, we have found potential benefits and inefficiencies with both private and public sector solutions to handling externalities. Tradable permits offer a combination of both types of solutions. When dealing with air quality, direct regulation policy is inefficient in that it is less expensive for some firms (in terms of actual costs and opportunity costs) to reduce pollution levels. The private market fails because clean air has the attributes of a public good which are under-provided for in a private market. Tradeable permits allow for the efficiency offered by a private market while forcing the realization of the externality costs caused by air pollution. A firm that can easily meet pollution regulations will do so giving these firms an incentive to sell their pollution permits to firms that face high costs in pollution reduction. If the government can issue the efficient amount of permits (which is not an easy task!), market transactions could result in an efficient level of pollution. This type of policy is often referred to as Cap-and-Trade Markets.